China and the dollar: Having it both ways

China made headlines across the globe this week with its call for establishment of a new currency to replace the dollar as the world’s reserve currency. The impeccable timing, just prior to the London G-20 summit, has allowed China to articulate the concern as a systemic one.

There may well be problems with the current dollar standard that underpins the world’s financial system. The dollar standard may also have had a role to play in the current crisis. But China’s real reasons are national: it fears the loss in the value of its reserves of $2 trillion from a sharp dollar decline. And that threat of dollar decline has suddenly become more immediate because of the dramatically increased vulnerability of the US government’s balance sheet.

But is China trying to have it both ways? It is seeing itself as the victim of the dollar standard when it has been, for a long time, a beneficiary and promoter of this standard.

Today’s problem is simply the natural culmination of China’s deliberate development strategy of mercantilism. To assess whether China’s fears are justified requires a benefit-cost analysis of the mercantilism as employed by Chinese leaders.

China’s development strategy has been simple and focused: export at all and any costs. To achieve this, China has maintained an undervalued exchange rate. This mercantilist strategy has empirical backing. Recent academic research (for example, by Harvard’s Dani Rodrik) supports the view that undervalued exchange rates can provide a means of escape from under-development and an engine of long run growth. So, China’s development strategy has been sensible.

But undervalued exchange rates, and the resulting rapid increase in export growth has also led to large current account surpluses. The Chinese authorities have intervened in foreign exchange markets to keep the currency from appreciating leading to a massive build-up of foreign exchange reserves. It is important to understand that this reserve build-up has been a consequence of the Chinese development strategy of mercantilism. Had the currency been allowed to appreciate, its current account surpluses would have been lower, and China would not have this pile of reserves to “worry” about.

The costs of mercantilism are essentially what China fears now: a substantial capital loss on the value of its foreign exchange reserves of $2 trillion. This risk, always understood as inevitable, has become urgent because the dramatic deterioration of the U.S. fiscal balance has brought forward the date of dollar decline. Suppose that the eventual dollar decline and re-equilibration of the yuan result in a 20 percent capital loss. This would amount to $400 billion or roughly 10 % of Chinese GDP.

But are these financial losses outweighed by the mercantilist growth benefits? Suppose that China cares about growth rather than consumption (we want to do the calculus in terms of the revealed preference of China’s leadership). Suppose too that undervaluation in China has worked and has generated higher growth over a period of time than would otherwise have been the case.

For China, let us for the sake of argument assume (conservatively) that mercantilism led to a higher annual productivity growth rate of 1 percent for a period of 10 years (this is consistent with the estimates in the papers by Rodrik and others). This extra productivity growth results, after ten years, in a level of GDP that is higher by 10 percent than it would have been otherwise. One year of this GDP gain is lost in the depreciation of the reserves. But this higher GDP is a permanent benefit that occurs every year and extends well beyond the ten year period. Precise quantification of the net benefits depends on many assumptions but the broad orders of magnitude are clear: the total GDP boost from mercantilism is substantially greater than the financial costs.

So, China should recognize the following. It deliberately chose a mercantilist strategy. That strategy yielded tremendous benefits in precisely the terms valued by the Chinese leadership. But it also entailed financial costs which are intrinsic to, and indeed the flip side of, the growth benefits. So, while its calls for re-evaluating the current dollar standard are welcome, they should not become an attempt by China to avoid these financial costs. These costs are unavoidable and moreover they are only a fraction of the growth benefits that it derived.

The world these days is finding it hard enough to bail out debtors. It would be something else if the world’s largest creditor also had to be bailed out, which seems to be the real motivation behind the Chinese call to change the dollar standard.

China and the U.S. are now like Siamese twins “leaking into each other,” in the words of Salman Rushdie, through trade and capital flows. China chose this embrace with its eyes open, as part of a bargain. It has enjoyed the benefits. It is now trying to avoid the costs by splitting off. But that is neither desirable nor should it be made possible.